Overview

Main Menu Name: Goodwill

Determines the value of a corporation's common stock by subtracting both liabilities and the par value of preferred stock from the value of the firm's assets. It then arrives at a per share value by dividing the number of common shares outstanding into the adjusted book value.

In this article:

• Background
• Getting Started
• Entering Data
• Results

Background

A closely held business should (and often does) produce an income in excess of the amount that could be expected from the mere employment of the capital its shareholders have invested. That additional amount of income is derived from an intangible value in the business, a value in excess of the total value of the tangible assets. This is called "goodwill."

By capitalizing this "earnings attributable to intangibles," i.e., by dividing the additional profits generated by the firm's goodwill by an appropriate rate, it is possible to estimate goodwill value. If this amount is then added to book (net tangible asset) value, an estimated total business value can be found.

Some of the elements that may comprise a firm's goodwill include:

1. Location of the business
2. Reputation of the business
3. Public recognition of the company's name
4. Lists of customers and prospects owned by the business
5. Management effectiveness and depth
6. Sales, operations, and accounting skills
7. Employee morale
8. Position of the business relative to competitors
9. Other factors that generate income in excess of that amount which could be expected after multiplying the value of tangible assets by a reasonable rate of return.

Note that goodwill does not include the portion of profits attributable to the corporation's ownership of patents, copyrights, formulas, or trademarks, even though they are intangible, since these are all specifically identifiable.

Goodwill, as is the case with other valuation formulas and procedures, should be used only as a guideline along with other valuation methods and not as the sole determinate of value. Goodwill has minimal relevance to the valuation of most investment companies since they usually do not have large amounts of intangibles. Officially the IRS does not give strong credibility to goodwill (although the IRS still insists that goodwill must be taken into account in the valuation process).

Getting Started

A closely held business often earns more income than could be expected from the mere employment of capital invested by shareholders. The additional income is a result of an intangible value in the business.

A business' goodwill value is estimated by capitalizing the "earnings attributable to intangibles." In other words, the additional profits produced by the firm's goodwill are divided by an appropriate rate. The good will value is then added to book value to determine the total business value.

A firm's goodwill includes the following elements: business location and reputation; public recognition of the company name; customers and prospects; management skills; sales, operations, and accounting skills; employee ethics; and competition. Goodwill does not include the portion of profits attributable to the corporation's ownership of patents, copyrights, formulas, or trademarks. Such items are intangible, but they are also identifiable.

Goodwill value should be used in conjunction with other valuation methods and not as the only method of valuing a business.

Entering Data

1.  Average Annual Earnings:  Enter the average amount of earnings made annually by the business. Earnings should be averaged over a representative period (such as the past five years) and weighted, if necessary.
2.  Estimated Capitalization Rate:  Enter the estimated capitalization rate. This value is the amount by which the earnings from intangible assets will be divided to arrive at the goodwill value.
3.  Average Annual Asset Value:  Enter the average annual adjusted book value of the business' assets.
4.  Rate of Return on Tangible Assets:  Enter the rate of return on the business' tangible assets.

Results

The calculation results show the company's return and earnings from tangible assets, earnings from intangible assets, goodwill value, and total business value. Results are displayed for the rate of return specified at the Rate of Return input, and for four additional rates.

To calculate these values, the calculation multiplies the average annual asset value by the rate of return to arrive at the "earnings from tangible assets." This value is than subtracted from the average annual earnings to arrive at the "earnings from intangible assets." These numbers are then capitalized (divided) by the capitalization rate to determine the "goodwill value." The final calculation, the "total business value," is the sum of each of the goodwill values and the average annual asset value.